The steel sector index has been moving sluggishly recently despite the improving Chinese blast furnace spread, which moves in line with stock prices. This is largely due to doubts over whether the Chinese blast furnace spread can widen further in 2018. However, given the conditions that surround the steel sector in 2018, we have a positive view toward steel shares. The blast furnace spread is improving as the price of iron ore falls and steelmakers continue to gain more pricing power thanks to ongoing industry consolidations in China. In terms of demand, oil-producing countries' steel demand is picking up on the back of oil price hikes and Chinese steel demand should also continue to grow thanks to the country's infrastructure investments.

Given the ongoing Chinese steel sector consolidations and a rise in iron ore supply globally, China's blast furnace spread, which moves in line with steel share prices, should improve further in 2018 as raw material prices decline. Higher oil prices are expected to boost oil producers' steel demand by about 5% in 2018. Soaring steel demand from these countries will have more impact on global steel supply-demand balance and prices vs. western countries. From 2018, Chinese steelmakers should enjoy bigger pricing power as the M&As among large-size steel names materialize. Additionally, China's Korea-bound steel exports are falling, which means Korea-based blast furnace names will have a stronger presence in the domestic market going forward.

We expect POSCO and Hyundai Steel to lead the sector index higher, riding on improving sector fundamentals. Declining imports from China and rising global steel demand should provide opportunities for Korean steelmakers to capitalize on the domestic and overseas markets. In the nonferrous segment, we recommend Korea Zinc, for the company has bright earnings prospects in 2018 backed by rising nonferrous metal prices and cost cuts through the streamlining of processes.

We maintain Overweight on the steel sector. As consolidations in China continue and global demand grows, the steel sector business environment should turn more favorable in 2018. Our investment points for the steel industry in 2018 are as follows:

1) China's steel mill spread (the spread between steel and raw material prices; moves in line with share prices) is expected to improve in 2018. Many believe that the current spread, which is the widest since the Financial Crisis of 2008, will be stagnant in 2018. However, given the ongoing steel sector consolidations in China and an increase in global iron ore supply, raw material prices are slated to fall, which will likely lead to wider spread.

2) While China, the US, and the EU contributed to global steel demand growth in 2017, in 2018, oil producing countries are expected to fuel steel demand as oil prices rise. The Middle East is a well-known net importer of steel and the CIS is a net steel exporter. Thus, the increase in demand from oil producers means growth in excess demand and a decline in excessive exports; thus, these countries will have a much stronger effect on global steel supply-demand balance and prices than western countries.

3) M&As of large steelmakers will begin to become more pronounced from 2018, following the closures of steel facilities and small steel mills over the last couple of years. As a result, the bargaining power of the steel sector, both in China and globally, will strengthen in the medium term, leading to higher profitability. Due to a decrease in capacity, China's steel exports to Korea started to decline sharply in 2017. As a result, POSCO and Hyundai Steel will be able to strengthen their position in the domestic market further.

We present POSCO and Hyundai Steel as our sector top picks and recommend Korea Zinc among nonferrous metal companies. We expect POSCO and Hyundai Steel, as the leading steelmakers, to lead the sector index higher in 2018 amid improving sector fundamentals. In 2017, the companies displayed the ability to pass raw material price hikes onto steel prices and to defend prices as much as possible when raw material prices fell. In 2018, as the market share of China-made steel is expected to decline, their bargaining power in the domestic market is likely to strengthen further. As for Korea Zinc, earnings visibility is set to improve on cost reductions as well as the prospect of nonferrous metal price rises amid USD weakness in 2018.

We believe POSCO and Hyundai will trade at higher P/Bs going forward. Chinese steel production utilization reflects the sector fundamentals, and it has historically moved in line with the sector P/B, thus the comparison between the Chinese utilization rate and the sector P/B is meaningful. As China's restructuring began in 2016 and demand started picking up, China's steel utilization rate is projected to rise to 81% in 2018, from 67% in 2015 and 78% in 2017. Against this backdrop, we believe the steel sector P/B multiple will rise.

When the Chinese steel mills ran at over 80% utilization, Korean steel shares traded at over 1x P/B. However, shares of POSCO and Hyundai Steel are currently trading at 0.61x and 0.43x P/B, respectively.

Compared with global peers, Korean steelmakers are undervalued, as their P/B, P/E, and EV/EBITDA are all lower.

Investors appear unsure as to whether the Chinese steel mill spread will improve further. Ironically, the major reason behind this skepticism is that the current spread is the best since the Financial Crisis of 2008.

However, as mentioned above, we believe that we should focus more on spread improvement in the future. The already closed steel mills are unlikely to restart, and the steel industry's price negotiating power will strengthen after a series of large-scale M&As. Also, the oversupply situation is expected to continue due to an increase in global iron ore supply. Accordingly, regardless of steel prices, the spread is likely to improve as raw material prices fall.

Of note, we believe the spread improvement seen in 2017 is due to Chinese steel sector consolidations. Beijing shut down about 111.5mn tons of capacity over 2016-2017, which worked to strengthen the bargaining power of the steel sector overall. Indeed, statistics show that in Jan-Oct 2017, the production volume of small Chinese steelmakers fell 8% YoY, and their share of total Chinese steel production volume dropped to 43% from 50% seen at end-2015.

Meanwhile, iron ore oversupply is expected to continue in 2018 globally. The number of new mines is limited in 2018 but those that came into operation in 2015-2016 are running at higher utilization rates, which means an increase in supply. We estimate global iron ore production volume to reach 2,132mn tons (+3% YoY) in 2018, exceeding the estimated demand of 2,082mn tons.

However, iron ore prices are unlikely to plummet. The newly added iron ore capacity will gradually decrease until 2019 from the 2016 peak and as global crude steel production (e.g. iron ore demand) has increased since 2016, iron ore oversupply is expected to ease gradually after the 2016 peak. Thus, it is reasonable to expect that iron ore prices will stabilize downward with far fewer fluctuations. The average annual iron ore spot price (CFR) is expected to be around USD69 in 2017 and USD60 in 2018 (vs. the consensus of mid-USD50).

In 2018, global steel demand is expected to inch up by 2.8% YoY. Despite pedestrian growth, we should pay attention to the 2018 demand because the quality of demand will improve as the demand from oil-producing countries increases. (In 2017, China, the US and the EU drove demand but in 2018, oil-producing regions such as the Middle East and CIS will join). The increase in demand from oil-producing regions is important because the Middle East is a well-known importer of steel (suggesting steel supply shortage) and the CIS is the region with the second-largest steel exports (suggesting excess supply), after China. Thus, increasing steel demand in these regions will have sizable effects on global steel supply-demand balance and steel prices.

These oil-producing nations account for about 10% of global steel demand, which is next to China and similar to North America and the EU. Steel demand typically moves in line with oil prices. We expect the oil price (WTI) to rise from USD50/bbl in 2017 to USD56/bbl in 2018 and as such, steel demand in oil-producing countries to increase 5% YoY in 2018, showing the sharpest growth alongside Southeast Asia. For reference, a 10% increase in oil prices had the effect of boosting steel demand by 4% on annual average from 2002 to 2007 and 7% from 2010 to 2012.

Meanwhile, according to market forecasts, power plant orders in the Middle East in 2018 are expected to increase by 15-30% YoY, and the CEO of Exxon Mobile (XOM) announced that the company will increase capex from USD17bn in 2017 to USD25bn in 2018. This means that steel demand in oil-producing countries such as the Middle East is likely to increase significantly

As oil prices rise in 2018, steel demand in the Middle East is projected to grow at a relatively high rate of 5% YoY. The Middle East's steel demand is about 57mn tons, which accounts for 3.4% of global demand (as of 2017). However, as the region mainly depends on imports to satisfy its demand, the increase in demand in the region mostly results in excessive global demand, which has a large impact on global supply and demand balance. The Middle East's steel net import volume is the second to Southeast Asia. Steel demand in the Middle East grew at a CAGR of 12% from 2002 to 2007. However, as oil prices fell, regional demand contracted in 2015 and 2016 and we believe consumption in 2017 stagnated as well at around 57mn tons.

On the supply side, the Middle East is characterized by a lack of large- and medium-sized steelmakers and low utilization rates. Some of the major steel companies in the Middle East include Iran's IMIDRO (25th in the world, 14.6mn tons in production volume in 2016), Saudi Arabia's Hadeed (66th in the world, 5.2mn tons) and UAE's Emirates Steel (95th in the world, 3.1mn tons). Only IMIDRO belongs to the medium/large-size category and the others are all small-sized companies. Another notable characteristic is that even when demand increases, the utilization rate in the region remains low at around 50%. This is largely due to the lack of utility and infrastructure such as power and water. Therefore, even if steel demand in the region increases in 2018, growth in the utilization rate will be limited and the region will have to depend on imports.

The CIS is the world's largest oil producer after Saudi Arabia and the US. As oil prices rise, the CIS' steel demand is projected to grow 5% YoY in 2018. CIS is the second-largest net steel exporter after China, producing 120mn tons of steel while consuming 55mn tons and net-exporting 42mn tons (as of 2016). As the CIS is located across Eurasia, increased net exports from the CIS had a massive effect on steel prices across Asia and Europe. However, if oil prices move upward going forward, steel demand in the region will increase and supply burden should ease as a result. Of note, when oil prices fell, the CIS' net steel export scaled back from 46mn tons in 2009 to 35mn tons in 2013 but it has since rebounded as oil prices declined.

The CIS has a number of mid- and large-sized steel companies, which dates back to the Cold War era. Due to oversupply, these companies' production capacity has remained flat at around 150mn tons over the past 10 years, and no capacity has been built additionally. Their main export destinations are Europe, Middle East and Southeast Asia. Major steelmakers include NLMK (16th in the world, 16.64mn tons capacity in 2016), EVRAZ (OTC:EVRZF) (23rd in the world, 13. 33mn tons), MMK (29th in the world, 12.2mn tons) and Severstal (SVJTY) (31st in the world and 11.63mn tons).

China: infrastructure investment to boost steel demand in 2018 In 2017, steel demand in China is estimated to have grown 3%, marking two consecutive years of growth (12% if factoring in the effect of induction furnace closures, which was not accounted for in the World Steel Association statistics; we used the WSA version for statistical consistency). The growth in demand was driven by various industries including construction (infrastructure and real estate), machinery, automobile, and home appliances.

In 2018, China's steel demand is forecast to grow 2.5% YoY. Increasing demand from the infrastructure, machinery and automobile sectors is expected to offset a decline in demand from the slowing real estate sector. The Chinese government needs to bolster infrastructure investment to shore up the economy, so infrastructure investment will likely drive steel demand in 2018. While investments in the AIIB project continue to grow, construction work for the development of the Xiongan New Area is expected to take off in earnest in 2018. Indeed, whereas real estate investment in China is slowing, infrastructure investment is gaining steam. In the stock market, there is skepticism about the growth of Chinese demand. However, considering that Chinese oversupply has weighed on the global steel sector for nearly a decade, we would interpret stable demand as positive as, even if it does not increase.

The consolidations in the Chinese steel sector are expected to continue in 2018. Beijing's initial target was to cut 110-150mn tons of capacity and make the top 10 steelmakers represent 60% of market share after large-scale M&As. The target to reduce capacity appears to be successful to some extent as capacity was cut by 65mn tpa in 2016 and 50mn tpa in 2017. This alone had the effect of keeping the Chinese steel mill spread at the widest level since the global financial crisis despite correcting iron ore prices. This shows the improved bargaining power of the steel sector after the exits of price-distorting small steelmakers.

M&As of large steelmakers are expected to accelerate in 2018. 2017 was a hiatus of M&A activities after the merger of Baoshan Steel and Wuhan Steel in 2016 (now called Baowu Steel). However, the Chinese Iron and Steel Association has recently mentioned about the necessity of M&As, and there is the talk of possible merger deals between Anshan Steel (OTCPK:ANGGY) and Benxi Steel as well as between Hebei Steel and Shougang Steel (OTCPK:SCGEY).

We believe that there is a high probability of M&A between Anshan Steel and Benxi Steel. In Oct 2017, China National Petroleum Corp (CNPC) acquired an 8.98% stake in Anshan Steel, in a similar step that it had taken ahead of the merger between Baoshan Steel and Wuhan Steel in 2016. If the M&A deal concerning Anshan and Benxi Steel comes through, the post-M&A entity will become China's second-largest and the world's third-largest steelmaker with crude steel production of 59mn tons (as of 2016).

Of note, in order to make top 10 steelmakers represent 60% market share, Beijing seeks to launch three to four super large steel companies with over 80mn tpa and five to eight big steelmakers with over 40mn tpa after a series of M&As. The M&As among large steelmakers, in our view, should further contribute to improving the price negotiating power of the steel industry.

China's capacity cuts are expected to help Korean steelmakers gain ground and improve profitability in the domestic market, because Chinese cheap steel exports are rapidly declining. China's monthly net steel export volume once increased from 2.2mn tons in 2010 to 8.3mn tons in 2015 due to capacity expansion. However, it has fallen to 8.3mn tons in 2016 and 5.3mn tons in 2017. As of Sep 2017, exports of long products from China were down 65% YoY and plates down 29% YoY. By region, exports to Korea fell 41%, Southeast Asia 56%, and Europe 24%.

The decline in China's cheap steel exports will serve as an opportunity for Korean steelmakers to further strengthen their position in the domestic market, especially for large companies with blast furnaces. Korean steelmakers' combined domestic market share moved at around mid-60% until 2016 but it is expected to expand to 68% in 2017 and 70% in 2018. Since Chinese long product exports plummeted in 2017, we see plate exports to fall going forward. Korean strip mill and steel pipe companies import 30% of raw materials from China, and now we expect them to shift to POSCO or Hyundai Steel instead. Domestic prices are usually higher than export prices, which should help boost the profitability of large domestic steelmakers with blast furnaces.

We believe nonferrous metal prices will continue to rise in 2018, because: 1) the dollar Index, which determines the direction of nonferrous metal prices, is expected to weaken; and 2) Chinese demand, which represents about half of nonferrous metal demand, is picking up.

Among nonferrous metals, zinc and nickel prices have risen by more than 30% vs. their 2017 troughs and the price of copper has increased by 25%. Overall, nonferrous metal supply is tight, which is due to the supply shortage and demand growth of concentrates. Globally, we estimate zinc was in shortage by about 900K tons in 2017 due to the shortage of concentrates but in 2018, the supply shortage should ease, to 260K tons. As for copper, consensus at the beginning of 2017 was oversupply but at this point we believe 2017 experienced a supply shortage of 90K tons and expect to see similar conditions in 2018.

Investment points include: 1) the prospect of a bigger domestic market share on reduced cheap imports from China; 2) Chinese steel mill spread, a key indicator of earnings and shares, is structurally improving and will be reflected into stock performance; and 3) valuation is attractive vs. global peers.

We forecast KRW29.44tn in parent revenue, KRW3.4tn in operating profit and KRW3.73tn in pretax profit for 2018. Operating profit should rise 12% YoY, displaying a third consecutive year of double-digit growth. Consolidated operating profit should come to KRW5.14tn on the back of stable earnings contributions from subsidiaries again this year.

Our earnings forecasts are on the very conservative side, factoring in only raw material price declines and sales volume growth. If ASP rises further, the company's earnings may surpass market expectations by a wide margin.

As for 4Q17, we expect parent operating profit to come in at KRW917.6bn, up 88% YoY and 27% QoQ. The robust growth in earnings is attributable to higher ASP, which is the highest level since 2Q12.

Shares have been moving around the low/mid-KRW300,000 level, because the market has been uncertain about the Chinese steel mill spread's further improvement as it is at the highest level in 10 years.

In our view, the spread's improvement is a structural improvement caused by Chinese capacity reductions and we believe there is further widening of the spread in 2018 given raw material price declines. Additionally, trading at 0.6x P/B, the stock is attractively valued vs. global peers.

Investment points include: 1) recovery of finished vehicle sales in China, which have been a major stock discounting factor; 2) the most attractive valuation compared with global peers (at 0.4x P/B); and 3) expectations that its domestic market share will grow, as Chinese imports start to dwindle.

We forecast KRW17.4tn in parent revenue, KRW1.49tn in operating profit and KRW1.33tn in pretax profit for 2018. Operating profit is expected to rise 11% YoY; on a consolidated basis, operating profit should increase 10% YoY to KRW1.64tn.

The reason that we believe earnings will grow is because we expect: 1) the company to be able to keep its ASP intact despite falling raw material prices; and 2) consolidated subsidiaries based overseas to report better earnings in 2018 after a sluggish 2017.

There are concerns that rebar demand has peaked but we expect 2018 rebar demand to hold up well at 11.8mn tons, only slightly down from the historical high of 12.6mn tons seen in 2017. Typically, 10mn tons in rebar demand are the threshold that separates growth from contraction of the rebar market. Given the estimated rebar demand of 2018, we believe steelmakers will have the power to turn it into a supplier's market.

Meanwhile, 4Q17 parent operating profit is estimated at KRW410.2bn, up 19% YoY and 34% QoQ. The robust growth is driven by strong seasonality as well as ASP hikes of plates and long products.

Shares have been trading below the early-2017 level, although shares of automakers and those that were hit hard by the THAAD tensions have rebounded amid thawing Korea-China relations.

Considering that stock discounts are disappearing and that the current valuation is attractive at 0.4x P/B, we believe shares will move in an upward direction going forward.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.